How does an investment valuation model work?

The two types of Investment Valuation models are relative and absolute models. The relative approach compares assets based on market price by using comparative ratios. The absolute approach, in contrast, seeks to determine fair value using an asset's expected cash flow value.

There are three primary methods for valuing investments, and each model has pros and cons of its own:

Dividend Discount Method:

The DDM is one of the most fundamental "absolute" systems. With this approach, the value of an investment is calculated using the company's dividend payments to shareholders. It works well for estimating the worth of an investment opportunity in a company that pays reliable and regular stock dividends. The concept is that an accurate estimation of the worth of the company's equity shares may be made by calculating the present value of dividend cash flows.

Discount Cash Flow Method:

DCF models are the best choice when a company doesn't issue stock dividends or when payments are irregular. The model calculates the company's discounted future cash flows in this case and compares them to alternative investments. For this strategy to be effective, the organization must have reliable, positive, and regular cash flows. These are often established companies that have finished their typical growth phases.

Comparable Method:

It is possible to think of the CM as a "relative" valuation method. When a discounted cash flow methodology cannot be utilized—for example, when the cash flows are negative or uncertain—this method is used in its place. By comparing it to the DDM and DCF models, it may also be utilized to determine the range or average value of an investment instrument. In order to assess if the stock is cheap or overvalued in comparison to other firms in the same industry, the CM examines company price multiples to an industry benchmark. The argument is that similar assets should sell for similar prices.